Who pays when purchase funds go missing?

In the case Johnson v. Schultz, et al., the Schultzes were in contract to purchase a home from the Johnsons for $277,500. The Schultzes hired a real estate attorney by the name of Parker to represent them in the transaction. Parker completed a number of tasks for the Schultzes, including completing a title search, procuring a policy of title insurance, preparing closing documents and a power of attorney, and actually performing the closing.

The Johnsons, who were familiar with Parker, paid him $125 to prepare the deed.

On Jan. 3, 2006, both parties attended the closing at Parker's office, and the Schultzes' mortgage lender, State Farm Bank, wired $200,320 into Parker's trust account. The Schultzes used their personal monies to pay the remainder of the purchase price.

That same day, Parker recorded the deed, rendering the Schultzes the legal owners of the home, and gave the Johnsons a check drawn on the trust account for the full purchase price. But when the Johnsons tried to cash the check several months later, it bounced.

A later investigation by the State Bar found that Parker had embezzled the funds from the trust account on Jan. 4, 2006 -- the day after the closing.

The Johnsons filed a lawsuit against Parker, the Schultzes, the trustee under the deed of trust and State Farm Bank, seeking either to have the conveyance reversed and to regain ownership of the property, or to receive $277,500 in damages.

All defendants except Parker, who reportedly admitted to having embezzled the funds, moved for summary judgment. The trial court ruled against the Johnsons (sellers), on grounds that because the sellers were entitled to the funds at the time they were embezzled, they bore the risk of the loss.

The Johnsons appealed and the appellate court reversed the trial court's ruling, deciding that requiring the buyers to bear the risk of the funds being lost via embezzlement by the closing attorney was "not only more consistent with how residential real estate transactions are generally closed in this state, but also produces a more equitable result."

The appellate court remanded the case to the trial court for the lower court to determine whether the Johnsons had also retained Parker as their attorney and, as such, should share in the loss.

On a further appeal, the highest court of the state reviewed the appellate court's decision. Before dealing with the merits of the case, the Supreme Court of North Carolina clarified that buyer and seller had chosen the settlement method of closing the real estate purchase transaction, rather than the escrow method.

The rule of law that had been applied by the appeals court, that the party entitled to the funds at the time of loss bore the risk of that loss, was applicable in North Carolina only to real estate transactions closed via the escrow method.

As a result, the Supreme Court ruled, the "entitlement" rule was inapplicable to the present case.

The state's Supreme Court turned to principles of equity to determine which party bore the risk of loss via Parker's embezzlement. The equitable law of agency did not apply, explained the court, because Parker was not acting within the scope of either his actual or apparent authority when he embezzled the funds.

However, a related equitable principle intended to prevent parties from benefiting from their agent's wrongdoing places the burden of loss on the party who "first reposed the confidence" in the wrongdoer that made the wrongdoing possible to occur.

Under standard real estate practices in the state of North Carolina, the buyer often selects and retains an attorney on behalf of buyer and his or her lender, and the seller often has the buyer's attorney perform a few limited functions, without retaining them as their attorney.

As a result, the buyer/client has legal recourse against his or her attorney who embezzles their funds that the seller does not have, including filing a lawsuit for damages from the breach of fiduciary duties and obtaining compensation from the Client Security Fund of the North Carolina State Bar (CSF) -- none of which remedies are available to the seller.

Because the Schultzes (the buyers in this transaction) first reposed confidence in Parker, their attorney, the court ruled that they bore the burden of the loss by virtue of Parker's embezzlement.